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3 Slices of the Market Ripe for Massive Moves in 2014

Keep a close watch on high yield, energy and healthcare

With a seemingly endless slow-growth economy and corporate revenues falling fast, it’s tough for the average investor to feel confident about a rising market.

However, in our book, a market bias simply isn’t a requirement for big profits.

That’s because for options traders, the thing to watch isn’t where the entire market is going — it’s the potential for very large moves in either direction. By looking beyond the broad market indices and delving into the individual sectors, we can identify the industries with the strongest and most predictable momentum, up and down.

Our approach focuses on big moves that can either catapult sectors or crush them, so we’ve researched the areas most primed for big market movement during 2014.

#1: The High-Yield Bubble Might Be Ready to Burst

High-yield bonds act very differently from investment-grade debt for a few reasons. First, they have much more credit risk than a Treasury bond or high-quality corporate bond. That is one of the reasons why high-yield bonds will often track stocks during market rallies. If investors think a default is less likely, then they require a lower yield on those bonds, and thus, prices rise.

However, as interest rates continue to rise (in this instance, from their May lows), the demand for high-yield bonds tends to fade a little because higher-quality debt is more attractive. Rising interest rates also reduce the value of those bonds, as they are discounted to match the new average yields. We expect high-yield bonds to finally give up a lot more of their premium as investors become more comfortable with the Fed’s moves to taper quantitative easing.

The perfect situation for high-yield bonds is one in which rates are relatively stable and growth looks good. With interest-rate volatility on the rise, and an emerging contrarian outlook on stocks, it seems unlikely that the high-yield market will be able to sustain further gains.

The most predictive pattern we have observed before high-yield bonds begin to sell off consists of two steps. First, investment-grade yields drop without a matching decline in high-yield bond prices. Second, stocks correct to the downside. The first stage of that setup emerged toward the end of September and, at this point, even a small correction to the downside in stocks could trigger a selloff in high-yield bonds.

A break like that doesn’t mean we are permanently bearish on bonds. Despite the onset of tapering, the Fed is still a big buyer and there is plenty of market risk for investors to fear, but if we had to pick one asset class to look for short-term bearish plays, this would be it. In the past, we’ve traded options on the iShares Trust Barclays 20+ Year Treasury Bond ETF (TLT) and the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), so that’s likely where we’d look for opportunities in 2014.

#2: Oil Prices and Energy Stocks

There are several reasons for the decline in oil prices since September, but the most significant is that the outlook for economic growth has dropped. That doesn’t necessarily mean that the entire market will decline, because the Fed can do a lot to put some support behind the broad market. However, they aren’t likely going to be able to stop the bleeding in the energy sector.

Oil stocks haven’t tracked this decline, which is much more unusual. Buyers tend to get overly optimistic just before the end of a bullish trend and will ignore bearish fundamental signals until it is too late. When this pattern plays out — which it quite often does — then the subsequent correction tends to be very sharp.

This kind of bearish divergence between energy prices and energy stocks tends to result in a short-lived correction unless the broader market also falls. We expect to see underperformance over the next quarter at minimum, but watch out for a decline in the S&P 500 that would drive energy stock prices much lower for a longer period of time.

In the past, we’ve traded in and out of names like Hess (HES), Marathon Petroleum (MPC), Schlumberger (SLB) and Chesapeake Energy (CHK), so we’d be inclined to play them again in 2014 if the opportunity presents.

#3: Healthcare Still Undervalued

Lest we look overly bearish and contrarian, we do think there are some very interesting bullish opportunities in the near term as well. Now that the government shutdown is behind us, at least temporarily, it seems even more likely that the Affordable Care Act will continue to be implemented, regardless of any pending modifications or delays.

Like several other sectors, healthcare has reached new highs, which is promising, but volume has yet to really confirm the rally. We like the prospects for healthcare in 2014, so we could recommend buying the next dip if it is confirmed with rising volume as prices rally.

It is worth noting that healthcare is considered a defensive sector during times of uncertainty. It’s not that healthcare stocks will rise when the market falls, but they tend to fall less and continue to rise if the broader indexes start to channel.

Considering the current level of uncertainty about economic growth in the market, we like the idea of looking for new opportunities to add defensive stocks to our portfolio.

The Bottom Line for 2014

Overall, there do seem to be some significant headwinds for further gains in the market, but it’s not quite time to become outright bearish. The trends we are anticipating are largely market-neutral, which is a prudent course for the near term. If the broader stock indices do start to sell off, there will be other opportunities, but for now it makes sense to concentrate on specific sectors and asset classes with the most significant trends.

Wade Hansen and John Jagerson may hold some of the aforementioned securities in their SlingShot Trader portfolio.